Companies need to ensure that they are prepared for the end of LIBOR. Internal reviews must be carried out at the earliest possible opportunity and appropriate systems should be put in place.
Financial market participants have been anticipating the cessation of LIBOR for several years, with December 31, 2021 originally forecast as the day that LIBOR would be officially discontinued. On November 30, 2020, the ICE Benchmark Administration Limited announced an extension to the date that most U.S. LIBOR tenors (other than one-week and two-week U.S. LIBOR) would cease being announced from December 31, 2021 to June 30, 2023. Aircraft financing contracts are generally denominated in U.S. dollars and often utilize one-month or three-month LIBOR, so this postponement will apply to most, if not all, aviation transactions. This eighteen-month extension is a welcome reprieve for aviation industry financiers, lessors and airlines who have been focused over the past year on the challenges presented by the COVID-19 pandemic rather than the LIBOR transition.
LIBOR replacement provisions in aircraft finance documentation have not evolved much since they first appeared after the announcement of LIBOR’s anticipated discontinuation by the UK Financial Conduct Authority in 2017. Following that announcement, parties to New York law governed aircraft finance transactions generally adopted the Loan Syndications and Trading Association (LSTA) “amendment approach” to the LIBOR transition. This approach contemplates that, upon the occurrence of a trigger event (typically a public statement or publication announcing that LIBOR will no longer be provided or is no longer representative), the loan agreement will be amended to replace LIBOR with a benchmark replacement selected by the agent following the trigger event. Typically, these provisions permit the agent to determine the specifics of these amendments, which are then posted to the lenders and the borrower and become effective within a short period of time thereafter, unless objected to by a majority of the lenders. In some cases, borrowers were successful in negotiating special consent rights with fallbacks based on treasuries or the Federal Funds Rate, plus an agreed spread.
More recently, the Secured Overnight Financing Rate (SOFR), a benchmark interest rate administered by the Federal Reserve Bank of New York, has been recommended by the Alternative Reference Rates Committee (ARRC) as the preferred successor to LIBOR in U.S. dollar financings. This recommendation has been embraced by the LSTA and, to a large extent, commercial lenders and borrowers. That said, the approach is not without its challenges. Unlike LIBOR, SOFR is an overnight rate, and is not forward-looking. The ARRC and LSTA anticipate that forward-looking term SOFR rates will emerge to fill the void created by the discontinuation of LIBOR, but this has not happened yet and so uncertainty around the nature of a SOFR-based rate, and post-LIBOR commercial loans, remains. Additionally, SOFR is generally lower than LIBOR because it is a secured and so-called “risk-free” rate, whereas LIBOR is unsecured and therefore includes a credit risk premium. LIBOR-based loans transitioning to a SOFR-based rate, whether it be a term rate or a daily compounded rate, will therefore need to incorporate a spread adjustment. For purposes of incorporating fallback language in loan documents today, the AARC and the International Swaps and Derivatives Association have recommended a spread adjustment based on the median difference between LIBOR and SOFR over a five-year lookback period occurring prior to a LIBOR transition event.
In August 2020, the ARRC announced that “hardwired” fallback language, rather than the “amendment approach” should be used in all new syndicated business loans starting in September 2020 and in all new bilateral business loans starting in October 2020. The “hardwired” approach sets out a hierarchy of fallback rates—first, a forward-looking term SOFR rate, if available, second, a compounded daily SOFR rate, and third, an alternative rate selected by the agent and the borrower after giving consideration to any recommendations by relevant governmental authorities or then prevailing market practice. At the time of writing, the hardwired approach is not figuring prominently in new aircraft financing transactions, although bank-originated deal flow since the onset of the COVID-19 pandemic has been substantially lower than in prior years, which has understandably slowed the pace of changes to market practice. A low interest rate environment has also led borrowers in new financings to lock in attractive fixed rates rather than adopt a LIBOR-based floating rate. That being said, market surveys indicate that the hardwired approach is gaining steam in the broader commercial lending market, and we expect that aircraft financing transactions will soon follow.
What Actions do Aviation Industry Participants Need to Take?
With the benefit of an extra eighteen months to prepare for the LIBOR transition, what actions should financiers, lessors and airlines take?
Aviation industry professionals must act quickly to devise and implement a strategy for the LIBOR transition, starting with a thorough internal audit of existing contracts and forms. While many would prefer that a clear market practice emerge in aircraft finance and leasing transactions before implementing a SOFR-based interest rate across their loans and leases, the imperative of achieving an orderly transition to a post-LIBOR world requires that all parties commence the process of transitioning their contracts now. The ARRC, ISDA and the LSTA have laid the groundwork, and the aviation finance and leasing industries must now start the work of implementing the transition, by adopting the “hardwired approach” to new LIBOR-based deals, eliminating unnecessary LIBOR references from fixed rate contracts, and devising a strategy to amend existing deals. By starting to plan for the transition today, lenders, borrowers and lessors will reap the most benefit of the eighteen-month extension to the life of LIBOR.